Empirical Study of Liquidity Effects in the Relation between Corporate Credit Spread and Credit Default Swaps

Abstract

The motivation of this study was to construct an empirical test to observe whether liquidity in Fixed Income and Credit Derivative markets have an effect on the theoretical relationship that link these markets. The test was performed taking daily quotes for 4,943 bonds and Credit Default Swap (CDS) Premiums for 3, 5, 7 and 10 years for 614 companies from UK and US markets. The total data collected amounted to more than 5 million singles quotes, which is considerably higher than previous empirical studies on the Credit Derivatives market. Liquidity effects were tested empirically through the construction of equally weighted portfolios based in measures that capture liquidity of securities. Each portfolio was rebalanced in a daily basis using information from 01/01/2003 to 31/03/2006. The main conclusions of this empirical study are: - Liquidity has empirical effects to the behaviour of the CDS Basis in a range of +22 to +80 basis points, and substantial increases in volatility were observed for all maturities. - Liquidity effect is different across maturities, eliminating the possibility to hedge positions using trading strategies in different maturities. - Bid-Ask spread is not enough to explain the deviations in the CDS Basis in low liquidity environments. When maturity increases, the explanation power of the bid-ask spread and transaction cost is not enough for the empirical deviation in the CDS Basis. - Credit Arbitrage trading strategies perform badly in low liquidity environments, even after adjusting for liquidity.